Country Risk Premium (CRP)

How to Calculate Country Risk Premium

The country risk premium (CRP) is an adjustment factor applied to calculate the cost of equity (ke), which represents the minimum required rate of return by shareholders, i.e. "hurdle rate".

In practice, the most common method to determine the cost of equity is the capital asset pricing model (CAPM), which is based on the premise that investors must be compensated with a higher return to undertake an investment of higher risk (and vice versa).

The country risk premium is meant to serve as additional compensation for the risks related to political instability, geopolitical risk, exchange rate volatility (FX), and economic fluctuations specific to a given country.

The inclusion of the country risk premium (CRP) is intended to adjust the cost of equity for the potentially adverse effects that stem from a particular country’s geopolitical environment and economic conditions.

The macroeconomic risks must be considered to analyze the risk of investing in securities where the underlying issuer’s financial and operating performance can be impacted by the risks outlined earlier, especially for multinational companies that operate in several countries.

The factors that determine the country risk premium include the given country's political governance system, risk of corruption, legal system, and geopolitical risk, such as the potential for war.

The more significant each risk component is for a particular country, the higher the country risk premium, which subsequently increases the cost of equity (ke).

Hence, a country with substantial geopolitical and currency risk such as Argentina has a much higher country risk premium (18.2%) compared to a developed country like the U.S. (0.0%).

^{Determinants of Country Risk Premium (Source: Damodaran)}

Damodaran Country Risk Premium Data (July 2023 Update)

The following data set, compiled by NYU professor Aswath Damodaran, contains the estimated country risk premiums (CRP) by country, as of July 2023.

Source: Damodaran

Country Risk Premium Formula

The formula to calculate the cost of equity with the country risk premium included is as follows.

In practice, additional premiums are added to the ERP when analyzing small companies and companies operating in higher-risk countries:

Where:

• Risk-Free Rate (rf) → The yield on debt issuances by the government – for example, the yield on the 10-year U.S. Treasury Note is the standard risk-free rate for companies operating in the U.S.
• Beta (β) → The beta is the risk measure in the CAPM formula that strives to capture the systematic risk of a given security – which refers to the portion of risk that is non-diversifiable in a portfolio.
• Equity Risk Premium (ERP) → The equity risk premium, or “market risk premium”, reflects the risk of investing in public equities, rather than risk-free securities, i.e. the difference between the expected market return (rm) and the risk-free rate (rf)

Country Risk Premium Calculator

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Country Risk Premium Calculation Example

Suppose we’re tasked with calculating the cost of equity (ke) of a publicly-traded multinational company, where a sizable percentage of revenue comes from China.

The yield on 10-year bond issuances by the U.S. government is 2.74% as of the present date, while the beta of the company is 1.12.

The equity risk premium (ERP) and country risk premium (CRP) of China, per the data set compiled by Damodaran, is 6.07% and 1.07%, respectively.

The inputs to calculate the cost of equity (ke) under the capital asset pricing model (CAPM) are as follows.

• Risk-Free Rate (rf) = 2.74%
• Beta (β) = 1.12
• Equity Risk Premium (ERP) = 6.07%
• Country Risk Premium (CRP) = 1.07%

After entering our assumptions into the formula, we arrive at a cost of equity of 10.6% for our hypothetical company with operations in China (and substantial exposure to country risk, like political instability, foreign tension, and cross-border regulatory changes).

• Cost of Equity (ke) = 2.74% + 1.12 (6.07%) + 1.07% = 10.60%

By incorporating the country risk premium, practitioners and investors in foreign markets can better analyze the risk-adjusted returns on potential investments.